Have you been unsuccessfully searching Netflix for a 72-minute documentary about index funds? Well, your wait is finally over. Game of Thrones, watch your back! 🙂

Also adapted from a book of the same title, Index Funds: The 12-Step Recovery Program for Active Investors systematically attacks the various reasons that people approach individual stock-picking and/or paying for actively-managed mutual funds. For example, there is the idea of picking an all-star manager, the idea of market timing, and the idea of picking individual stocks.

I would warn that content is targeted more towards investors with some experience and less towards novices. They apparently also recognized that the material can be rather dense, and thus also broke it up into 12 parts. Here is Part 1:

Both the book and film were created by Mark Hebner of Index Fund Advisors (IFA), a fee-only wealth management firm that offers mutual funds from Dimensional Fund Advisors (DFA). Found via co-producer Robin Powell. As the book promotes the purchase of DFA funds, which can only be bought through affiliated advisors such as IFA, the material can be seen as self-promotional. However, having read the original book 10 years ago, I did not feel that the content was overly self-promotional. If you focus on the academic research by Nobel Laureates and historical data presented, there is a lot of useful knowledge to be gained.

If you’re interested in more detail, you can buy a physical copy for $8 at Amazon, a Kindle eBook version for $3, or you can navigate through all the content online at IFA.com for free.

From time to time, people ask to send me details of their current portfolio for some advice. I usually decline respectfully as I don’t feel qualified to provide specific investment advice, but I did accept a copy of the general fee schedule for Fidelity Portfolio Advisory Services (PAS) as of March 30, 2016. Here is a scan of the Annual Advisory Fee Schedule:

Note that the Net Advisory Fee = Gross Advisory Fee – Credit Amount. From the client agreement:

Your Gross Advisory Fee does not include underlying fund expenses charged at the individual fund level for any funds in your Account. These fund expenses, which vary by fund and class, are expenses all fund shareholders pay. Some of these underlying fund expenses may be paid to Strategic Advisers or its affiliates and will be included in a Credit Amount, described below.

In other words, the credit amount is the fees and compensation that your advisors get paid in exchange for picking those investments over the other investments that may not pay such fees. It doesn’t make much difference, as these fees are usually passed onto the retail customers anyway, just indirectly through the mutual fund annual expense ratios. As a result, the gross advisory fee is still the minimum amount that the end customer will pay.

Let’s take a look at what this means:

• For a $1 million portfolio invested in a Fidelity Model asset allocation, you’d be paying 1.27% of your assets to Fidelity on an annual basis in exchange for them managing your portfolio. That’s $12,700 a year automatically deducted from your account.
• For a $1 million portfolio invested in a Fidelity “Index-Focuced” asset allocation, you’d be paying 0.85% of your assets to Fidelity on an annual basis in exchange for them managing your portfolio. That’s $8,500 a year automatically deducted from your account.
• The annual fee above does not include underlying fund expenses. The brochure did not include any specific asset allocations, but this will add another layer of expenses. For example, their Fidelity Strategic Advisers® Core Fund (FCSAX) has an expense ratio of 0.67%.

Consider that many institutions believe that for the next 10-20 years, you’d be somewhat lucky to get a 4% return on balanced portfolio after adjusting for inflation. Put another way, let’s say your $1,000,000 portfolio might provide 4% in inflation-adjusted annual income, or $40,000 a year. With Fidelity PAS, your annual advisory fee of 1.2% would equal $12,700. That would already eat up over 30% of that theoretical income and is before fund expenses. All-in, you’re looking at close to 40% of your potential pre-tax return eaten up by management fees.

Now for my personal thoughts. Briefly, in my opinion, the Fidelity PAS marketing materials (sample brochure) promote their high number of sub-advisors and complexity to suggest that they offer something worth paying a lot of money for. In my opinion, I do not see any evidence that one will receive enough additional return to offset the relatively high fees. While I am a Fidelity self-directed brokerage client and use some of their other products and services, I would not invest my own money in this Portfolio Advisory Service. There are many managed portfolio services like Betterment, Wealthfront, Schwab Intelligent Portfolios, and even all-in-one funds like Vanguard Target Retirement funds which I would recommend my own family members first if they chose not to learn how to do-it-yourself.

Here are some helpful resources on owning only bonds of the highest credit quality as part of your portfolio asset allocation.

• David Swensen in his book Unconventional Success argued that alignment of interests is important. With stocks, the exectives want to make profits, and you want them to make profits. With stocks, your interests are aligned. In contrast, the job of bond issuers is to look as creditworthy as possible, even if they are not. This keeps the interest rates they pay lower. With bonds, your interest are not aligned. The safety ratings of bonds usually only get worse – usually quickly and unexpectedly as we saw with subprime mortgages. Ratings agencies are not very good at their jobs, mostly in a reactionary role, and are often paid by the same people they rate.
• Larry Swedroe at ETF.com:
  

  However, he also observes that the primary objective of investing, at least in stocks, is to make money. On the other hand, he makes an important distinction when it comes to the primary objective of investing in bonds, which is to help you stay invested in stocks when the inevitable bear markets arrive.

  And that leads to his conclusion to invest the fixed-income portion of your portfolio in only the safest bonds (such as Treasurys, FDIC-insured CDs and municipals rated AAA/AA).

  The overall idea to is own the safest thing possible when it comes to bonds.

• Daniel Sotiroff at The PF Engineer:
  

  The primary reason most investors own fixed income securities (bonds) is their ability to limit declines in portfolio value during periods of poor stock performance. From this perspective there is another dimension to safety in the fixed income universe that needs to be understood.

  […] Almost all of the non-Treasury securities experienced a drawdown during 2008 which peaked around October and November. Investors holding corporate bonds, intermediate and longer term municipal issues, and inflation protected securities were no doubt disappointed that their supposedly safe assets posted losses. Corporate bonds in particular have the unfortunate stigma of behaving like stocks during crises. Adding insult to injury those disappointed investors were also faced with taking a haircut on their fixed income returns if they wanted to rebalance and purchase equities at very low prices. Thus there is more to risk than the more academic standard deviation (volatility) of returns.

  My interpretation is that he concludes that intermediate-term Treasury notes are good balance of safety and interest rate risk, while short-term Treasury bills are for those that really don’t want any interest rate risk.

• Also see this previous post: William Bernstein on Picking The Right Bonds For Your Portfolio

A reader recently sent me a set of articles by Scott Burns about a person he calls the Rational Gold Investor here and here. I’ve been a long-time reader of Scott Burns because while he has been a steady proponent of passive and low-cost investing, he isn’t afraid to consider other investment alternatives.

Shayne McGuire manages gold investments for the Texas Teachers Retirement Fund, is the 18th largest pension fund in the world with over $120 billion in assets. He does not believe in gold as only a “armageddon” asset, but something that everyone should own a little of as part of a diversified portfolio.

Read the full article, but here are highlights from the interview:

• Gold has never been more under-owned as an asset.
• The supply of gold is difficult to increase.
• Financial leverage in the world economy has never been higher.
• Gold is an asset class that competes against equities and other asset classes, generally on a weaker footing becausen the long run (periods like 25 years) it cannot outperform stocks, bonds or real estate.
• Gold tends to like bad news. If houses go down, it tends to go up. It makes you feel like you’re betting against the home team.
• A lot of peculiar people seem to like gold and that makes people not want to be like them.

In other words, there are legitimate reasons to own some old, even if you don’t believe that the collapse of fiat money is imminent. At the same time, I think it is important to focus on the real numbers:

• The pension fund invests less than 0.5% percent of their assets in gold, and this number has never been higher than 1%.
• The value of all the gold in the world is about 0.6 percent of all financial assets. In 1980, the number was 2.5%.

In other words, the Texas Teachers Retirement Fund only keeps roughly a world market-cap weighting of gold, even if that amounts to roughly $70 million. Here that number is stated as 0.6%, while the previous source I quoted had it at 1.3%. Let’s split the difference and call gold’s world market-cap at roughly 1%.

If you had a $100,000 portfolio, 1% would work out to $1,000, which you could round off to a single 1 oz. gold American Eagle or Canadian Maple Leaf. They also make 1/2 oz, 1/4 oz, and 1/10 oz versions. I like the idea of holding physical gold here because you would have zero ongoing management fees (unlike an ETF), you maintain full control of the gold (away from any government), and you’d be more likely to hold it for the long-term (buy/sell spreads are big). Even if you had a million-dollar portfolio, a 1% allocation to gold would weigh less than a pound and fit inside your clothes or virtually any hiding place.

Buy a little bit of gold, put it somewhere secure, and rest easier knowing you have a slightly more diversified portfolio and a bit of insurance. At the same time, most of your money is still invested in productive assets like solid companies around the world or a rental property.

Another source of investment research and market commentary that I track is from Callan Associates. You may recall the name from their annual Callan Periodic Table of Returns. In addition to that, Callan offers free access to their entire Research Library with your e-mail address. Their focus is on institutional investors, but there are often things of interest for motivated individual investors. Some of my highlights from their 1st Quarter 2016 papers:

A discussion of investing in “real” assets such as real estate, TIPS, and commodities. As they point out, the best time to consider an inflation hedge is when the risk is considered low. Here a chart of 15-year historical returns vs. volatility for various asset classes.

I would note that it can be very difficult (if not impossible) for an individual investor to get low-cost, diversified, direct access to certain asset classes like timberland and farmland. There are some ETFs being marketed, but they do not provide pure exposure. If you have many millions if not billions, not a problem.

10-year capital market projections. Each year, they share 10-year projected returns for major asset classes. They also go out on a limb and make predictions about expected standard deviation and correlations, which I think is rather bold (and thus I shall ignore it). Below is a partial snapshot (click to enlarge). Download their full report for the test.

Returns are nominal, and their inflation projection is 2.3%. If you are looking for a more optimistic outlook, Callan’s projections are overall higher than many others I have seen. If the predictions of +7.4% annualized returns for US Stocks, +7.6% for International Stocks, and +3% for US Bonds all hold, I will be a happy camper.

Here are my notes and takeaways from the GMO Quarterly Letter for Q1 2016, released May 10th, 2016. I always pick up something educational when reading these letters (previous editions may require free registration.) I already discussed their Q1 2016 Asset Class Forecasts with the previous Q4 2015 letter, but in the future I’ll try to align the same quarterly information into one post.

GMO investment philosophy is that asset prices will eventually mean-revert back to their historical valuation levels. However, “eventually” can mean prices moving in the opposite way for a very long time periods. Right now is one of those periods:

It’s no secret that the last half decade has been a rough one for value-based asset allocation. With central bankers pushing interest rates down to unimagined lows, ongoing disappointment from the emerging markets that have looked cheaper than the rest of the world, and the continuing outperformance from the U.S. stock market and growth stocks generally…

Of course, such deviations are exactly the source of potential excess returns for such value investors. GMO still believes in long-term value-based asset allocation.

A quick primer on how future returns work for bonds. Excerpt:

It is universally understood (I hope) that a 10-year Treasury note yielding 1.84% held for 10 years will give a return pretty close to 1.84%. It is not quite so widely known that the rate of return of a dynamic portfolio of such bonds – a “constant maturity strategy” – is also pretty well fixed for certain time horizons.

To take the Barclays U.S. Aggregate Bond index (Agg) as an example of a dynamic portfolio, with a duration of a little over five years and a current yield of 2.17%, the range of possible returns over the next seven years is not very wide. We are not guaranteed to get 2.17%, but the return if the yield were to gradually drop to zero over that period would be about 2.9% per year, and if the yield were to gradually double, it would be about 1.5% per year. No matter what happens to yields over the next seven years, returns are going to be something pretty close to 2.17% on the Agg.

Wrong prediction on oil prices. In 2005, Grantham made a rough 10-year prediction that rising oil prices were not in a bubble, but instead actually a “paradigm shift” where oil prices would stay high permanently. He also predicted that we would start to run out of other finite resources, resulting in higher commodities prices. As it turns out, we saw that oil prices have crashed along with other commodities. Grantham outlines again why he made the prediction, what he got wrong, and of course goes ahead and makes another set of predictions:

– Oil stocks should do well over the next five years, perhaps regaining much of their losses. But, after 5 years, prospects are more questionable, and, beyond 10 years, much worse.

– Mineral resource stocks are unlikely to regain their losses, but from current very low prices they will probably outperform based on historical parallels following similar major crashes.

– Farmland is likely to outperform most other assets. It is still my first choice for long- term investing.

– Forestry should perform above aggregate portfolio averages and be less volatile than equities.

Why should we listen to this new forecast when his last one was wrong? It all goes back to the first point of the letter. These are all long-term calls based on history and a bit of common sense. Grantham is telling you to buy exposure into finite resources – oil, minerals, farmland, and timber. Sooner or later, if you have something that everyone needs like oil and is also selling at historically very low prices, prices are going to go back up eventually.

The problem is “eventually” could be this year, or it could be another 10 years or more.

High US housing prices are more worrying than high US stock market prices. Housing prices are certainly bouncing back…

…the threshold for a bubble level for the U.S. market is about 2300 on the S&P 500, about 10% above current levels…

… Thus, unlikely as it may sound, in 12 to 24 months U.S. house prices – much more dangerous than inflated stock prices in my opinion – might beat the U.S. equity market in the race to cause the next financial crisis.

Climate change warning.

Let me just make the point here that those who still think climate problems are off topic and not a major economic and financial issue are dead wrong. Dealing with the increasing damage from climate extremes and, just as important, the growing economic potential in activities to overcome it will increasingly dominate entrepreneurial efforts in future decades. As investors we should try to be prepared for this.

You read this letter for Grantham’s opinions, and you definitely get them. Personally, I don’t see anything that would change my boring portfolio. If anything, I would make sure to have some international exposure to emerging markets stocks as they have low historical valuations and are also correlated with commodities.

Research Affiliates, an asset-management firm founded by Rob Arnott, also offers long-term forecasts across a variety of asset classes via their Expected Returns tool. Here is a paper explaining their equities methodology [pdf]. I would like to note down some of these predictions, in the hopes of coming back later and seeing how they turned out. I’ve already been around over 10 years, what’s another 10? 🙂

Here is what they have as of April 30, 2016 (click to enlarge):

Overall, their conclusions suggest that we should have very modest expectation for US stocks and US bonds, while some international diversification can help boost expected returns. More specifically:

• Future 10-year average returns for US Stocks are expected to be very small on an inflation-adjusted basis (between roughly 0%-1%). US equities are highly-valued based on historical values.
• Broad US (Core) Bonds, Long-term US Treasuries, Short-Term Treasuries, and TIPS are all expected to have low forward returns (between roughly 0%-1%). Their low current yields offer little other alternative prediction.
• Relatively bright spots, at least returns-wise, include Emerging Markets stocks, Developed International (EAFA) stocks, and Emerging Markets bonds (both local and non-local currency).